Economics: Tax rise is the Chancellor's safest option

THE KEY question that the Chancellor has to address between now and his Budget on 30 November is by how much to raise taxes. Kenneth Clarke has ruled out further public spending cuts, so taxes are the operative part of the equation. But his Budget judgement is by no means easy. First of all, he has to decide what his long-term target for the deficit should be.

The Chancellor could aim at broad balance, taking the economic cycle as a whole. This was the Government's objective at the end of the Eighties, when Nigel Lawson thought the exchequer was in comfortable surplus. However, Mr Clarke would find the target too onerous. The last Budget forecast in March predicted that the deficit will be 3.75 per cent of national income even in 1997-8. To bring this back to balance in that year - when the economy should be growing in line with trend - would take a rise in the VAT rate from 17.5 per cent to 27.5 per cent.

Fortunately for Mr Clarke's political career, there is no particular economic reason for aiming at budget balance despite its pleasingly Gladstonian ring. Budget balance implies that the national debt stays stable in cash (nominal) terms. But in a growing economy, this means that debt steadily shrinks as a proportion of income. That objective may make sense for a mortgaged homeowner with a finite life expectancy, but nations go on and on. There is no need for a time limit.

Another common criterion is that the Chancellor should stabilise the national debt as a proportion of the economy (or Gross Domestic Product). The thinking here is that we should not saddle future generations with a higher tax rate just to pay interest on the national debt. This ratio is currently growing rapidly, as it always does when recession cuts tax revenues and boosts spending. It will reach 50 per cent in 1997-8 according to the March Budget forecast.

Because the debt will be half of national income when the economy is on trend, the calculation of a sustainable deficit is fairly easy. Essentially, the Chancellor can afford to borrow half of the growth rate of the economy. If he does, the debt to GDP ratio will remain stable at 50 per cent.

If we assume that the real trend growth of the economy is 2.25 per cent a year, and that the Government is aiming to deliver 2.5 per cent inflation each year (the middle of its 1 to 4 per cent target), then the total growth of the economy in cash terms will be 4.75 per cent a year. The sustainable deficit is half - 2.4 per cent of GDP.

This calculation highlights the importance of the target for inflation. Suppose for an instant that Mr Clarke developed slightly Latin American tendencies, and was to aim for 7 per cent inflation instead of 2.5 per cent. He would then be able to borrow half of 9.25 per cent - inflation plus real growth. This is 4.6 per cent of GDP. If the last Budget forecast is right, he would have no need to raise taxes.

If, on the other hand, Mr Clarke were to develop a teutonic bent, deciding to aim at zero inflation, he would have to squeeze the deficit to just 1.1 per cent of GDP. Massive tax rises would be in prospect if he were to persuade the financial markets that he was serious about his inflation target. So the key decision on the deficit depends on the inflation target.

At present, the financial markets do not quite believe that the long-run inflation rate will be in the middle of the Government's range, a scepticism due in part to the large prospective budget deficits. If the Chancellor is to persuade the markets that he is aiming at 2.5 per cent inflation, he will either need to show that the March Budget forecast overestimated the long-run deficit, or he will have to raise taxes by about 1 per cent of GDP or some pounds 6.5bn. That is worth a rise in the VAT rate to 20 per cent.

I have presented a simplified version of the debt arithmetic. Those who would prefer a more sophisticated expose should read Gavyn Davies's useful paper on optimal fiscal policy, which will be included in the Goldman Sachs/Institute for Fiscal Studies green budget. Mr Davies rightly points out that the type of calculation performed above is based on the wholly arbitrary decision to stabilise the debt to GDP ratio at about half.

There is no obvious reason why the Chancellor should pick this number rather than another. By coincidence, it also happens to have been the ratio at the time Baroness Thatcher became prime minister. Mr Davies points out that it is far lower than the ratio in Italy (115 per cent) or Canada (86 per cent) and broadly in line with Germany (47 per cent), France (57 per cent) and the US (65 per cent).

Another possible criterion for deciding on the long-run deficit is the golden rule. This is the continental notion that government should only increase its borrowing to the extent that it is creating new wealth. In other words, the public sector ought to pay as much attention to its own balance sheet of assets and liabilities as a private company. Its stock of wealth matters.

Happily, UK (Government) plc is still solvent. Even though it is now borrowing far more than it is creating in assets, the official statisticians estimate that tangible public sector assets were worth pounds 374bn in 1992 compared with pounds 174bn of net financial debt. However, the balance sheet has been deteriorating at a rapid rate since the late Eighties, both because of borrowing and asset sales.

We could try to bring borrowing in line with asset creation, taking the boom and bust cycle as a whole. On Mr Davies's calculations, the borrowing requirement would need to be between pounds 20bn and pounds 24bn a year to observe the golden rule. This is about 2.7 per cent of GDP. By coincidence, this is also his estimate of the deficit needed to stop a rise in the debt-to- GDP ratio at the Government's mid- target inflation rate.

However, the golden rule also has its drawbacks. There is little point in building glistening new schools (which count as capital investment) if there are no teachers to teach in them. And it is arguable that the Government should take account of the overall investment in the economy, which might be higher if it uses its Budget policy to avoid sharp swings in the business cycle.

Given the imponderables in choosing a path for the long-term deficit, it would be sensible for the Chancellor to rehearse his thinking in the Budget Red Book. His reasoning will largely determine whether the markets believe his inflation forecasts, and therefore may also help to determine the cost at which the Government is able to finance this year's pounds 50bn deficit.

The new Treasury forecast may, of course, show that the deficit will fall to around 2 1/2 per cent of GDP in 1997-8 without further tax increases. A difference of one percentage point compared with the Budget forecast is well within the margin of error. The Chancellor could also assume that the economy will grow more quickly or that he will be able to borrow money more cheaply.

But if Mr Clarke is seen to be hoping for the best, the markets are likely to remain sceptical. Chancellors who fail rarely do so because they are wicked, but merely because they indulge in wishful thinking. Nor do political considerations necessarily favour over- optimism. The timing of the electoral- economic cycle surely means that Mr Clarke would be wise to err on the side of caution, so that any surprises close to the general election are pleasant ones. The only respectable reason for avoiding a further fiscal tightening in the Budget is the worry that tax rises might stall the recovery. This is a real concern, but my instinct is that they will not. That fear should be offset by further easing in monetary policy. Another one percentage point off interest rates - with a further point in reserve - should keep domestic spending edging upwards, and ensure that sterling does not rise as continental rates come down, preserving our export competitiveness.